Crisis and Regulation, part three: Conclusion via Cochrane

A while back I did a two-parter on the financial crisis that I never finished with a conclusion (typical). The second post proved massively popular due to a graphic of the "securitization chain" that google decided was mine instead of the site I grabbed it from (awesome). 

In any event, I meant to end the series by saying that the solution to preventing another financial crisis would be to not only end "Too Big to Fail" as Bernanke says, but to re-structure the banking sector so that it is comprised of lots of small and medium sized banks, the failure of any one of which would not be consequential to the whole sector. In this way, the financial sector would be like any competitive industry we fetishize in our micoeconomic models, where market forces diseminate best practices, prices are at socially-maximizing equilibrium, and systemic risk is minimal to non-existent. 

And in a counter-intuitive fashion, I concluded that more government regulation of the sector could prove counter-productive to his end. Instead of going over the specifics of this, I found this handy quote for John Cochrane in the WSJ circa Dec. 2011 that sums it up better than I can: 

"The depressing scenario is that the six big banks will use this massive regulation as an anti-competitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with ontinuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965. The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year's Dodd-Frank financial legislation and the Fed's rules, which allow the government to step in whenever they decide that a financial risk is "systemically important." What is not "systemically important?" How I can I build a new financial company that demonstrably causes no "systemic" danger—and is therefore not subject to the Fed's onslaught of regulation, discretionary supervision and "remediation"? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized "resolution"?

Monetary v. Financial Policy at the Fed (part 2)

Here's that quote from John Cochrane I alluded to earlier about how the Fed is doing more "financial" rather than traditional "monetary" policy: 

"Leaving aside the string of bailouts, the Fed started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private debt. Though the funds rate was near zero, the Fed noticed huge commercial paper and securitized debt 

spreads, and intervened in those markets. There is no “the” interest rate anymore, the Fed is attempting to manage them all. Recently the Fed has started buying massive quantities of mortgage-backed securities and long-term treasury debt. Monetary policy now has little to do with “money” vs. “bonds” with all the latter lumped together. Monetary policy has become wide-ranging financial policy."

The point is, when you couple this quote with pretty much everything Scott Sumner has ever said, you get a picture of an institution that is wildly off course. Instead of buying short term Treasury debt for cash and using this mechanism to boost nominal spending along its previous trend, the Fed is instead trying to coax a recovery by manipulating strategic asset prices and rates of return it thinks are crucial.  

This is both dangerous and ineffective. 

Monetary v. Financial Policy at the Fed (part 1)

Nominal GDP growth as been slight to say the least over the past four years. In that time, however, the monetary base has roughly tripled. This implies that demand for base money has risen almost as much as the supply of base money, or that velocity has fallen roughly in tandem (Recalling that MV=PY).

Its not hard to figure out where this base demand is coming from: member banks have increased holdings of excess reserves at the Fed dramatically. See below.

Maybe it has something to do with the fact that the Fed is paying them 0.25% on those reserves. Accounts at the Fed are where money goes to die sit, not get lent out to businesses or circulated by consumers. Ordinarily, banks keep some reserves at the Fed to meet their reserve requirement, not stash hundreds of billions there.

Why, then, would Bernanke's regime implement such a contractionary policy? Its because the Fed has, since 2008, been much more interested in setting what John Cochrane called "financial policy" than monetary policy. While indicators such as below-trend inflation, high unemployment, and low NGDP growth would scream for more monetary expansion, the Fed has been intent to manipulate specific portions of financial markets. For example, below is the Fed's holdings of mortgage backed securities.

Crisis and Regulation, part two: Enter the Investment Banks

At the end of Crisis and Regulation Part One I said that mortgage lenders packaged mortgages they had made together into mortgage-backed securities, and then sold them to "someone else." This meant that because they quickly unloaded the mortgages, mortgage standards declined, which many loans given to the NINJAS. The "someone" who bought these mortgage securities were the investment banks- think Goldman Sachs, Bear Sterns, Lehman Brothers, Morgan Stanley ect.

Now a word about invesment banks: the process of investment banking is essentially the inverse of the process of commerical banking. Investment banks purchase securities from issuers and then sell them to the final investors. For example, investment banks are how firms sell stock when they wish to issue more: Goldman Sachs will purchase x number of shares from Apple and then sell those shares to the general public; the margin between the purchase price from the issuer and the price they get from the public is their profit. So investment banks act as an intermediary between those selling assets and those wishing to buy them, as opposed to commerical banks that act as an intermediary between people buying assets (depositors) and those selling them (borrowers). But the big difference between investment and commercial banks is that investment banks do not hold assets on their balance sheets for very long; its a quick-turnover business, at least if done profitably: they want to flip the securities they have underwritten to a buyer quickly to get the margin of profit, as opposed to commerical banks who hold their liabilities (deposits) and assets (loans and other securities) on their balance sheets for a longer period of time.

But what are the implications of this for the financial crisis? Well, the investment banks were the critical link in the securitization chain that spread the risk of mortgage default from the originators of the mortgage to the broader financial system; if the investment banks had not underwritten the mortgage securities from the originators and sold them to other investors (such as commerical banks, pension and mutual funds, sovereign wealth funds, ect) the financial contagion would not have happened...

but why was it all able to go so wrong?

Here's that interesting piece by the guy who left Goldman Sachs...

I thought this was an interesting bit of candor from someone who actually worked in the depths of the financial services industry. And seeing as how I'm in the mist of a series of posts on the subject of the financial crisis, quite appropriate. Follow the link and the NYT won't dock you one free article view of the month. Enjoy.

http://www.nytimes.com/2012/03/14/opinion/why-i-am-leaving-goldman-sachs.html?pagewanted=all

Crisis and Regulation, part one

I watched Inside Job for the first time this week, and it got me thinking about financial regulation and the crisis of 2008. What struck me most about the whole thing was how ill-designed the subsequent Frank-Dodd regulatory bill was.

To start with, lets investigate my diagnosis of what caused the financial crisis, and what did not. The crux of the problem was asymetric information, where one side in a transaction has more information than the other. With asymetric information, markets cannot funciton efficiently because supply and demand equilibrium rely on both parties maximizing their utility; with asymetric information, prices will either be too high or too low, depending on whether the buyer or seller has the information advantage.

This was exactly the situation that arose in the market for mortgage-backed securities. Mortgages of individual homeowners were combined into securities and sold by the original lending institution. The mortgage payments from the mortgages that comprised the security than went to the new owners of the security.

Many of these securities were backed by mortgages that were given to NINJAS- no, not those ninjas, but people with No Income, No Job, No Assets- obviously the type of person who is likley to default or at least be delinquent on their mortgage. But the originators of these loans did not care, because once the made the loan, they simply combined the bad mortgages into mortgage-backed securities and sold them to someone else.